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Monday, March 26, 2007

Housing Market Blues

Posted: Friday, March 23, 2007

Publication Date: March 23, 2007

Resident Fellow Desmond Lachman

As in a Greek tragedy, the present unraveling of the U.S. housing market is being accompanied by all too predictable choruses. At periodic intervals, the Wall Street economist chorus assures us that the worst of the housing downturn is over and that the spillover affects to the rest of the economy will be minimal. For its part, the policymaker chorus intermittently spouts forth soothing words to calm nervous markets at this time of heightened investor uncertainty. And these choruses get rudely interrupted every now and again by ever worsening data coming out of the housing market only to start the cycle of reassuring choruses anew.

While the inclination of policymakers to act as cheerleaders is perfectly understandable, one can only hope that they do not allow their positive spin to blind themselves to the likely need for early monetary policy easing. For an aggressive easing in interest rates will soon be needed to limit the economic fallout from the housing bust that now appears to be in full swing.

In the debate as to where the housing market might be headed, all too much attention has centered on the grave troubles now surfacing in the sub-prime mortgage market rather than on the gross excesses that characterize the overall U.S. housing market. In particular, scant attention is being paid to the fact that housing prices in constant dollar terms surged by a staggering 70 percent between 2000 and 2006, or by an amount that has no precedent over the past 100 years. Nor is much attention being focused on the fact that the remarkable relaxation of mortgage lending standards over the past six years has raised the percentage of U.S. households owning homes from a fairly stable historical average of 64 percent to almost 70 percent by 2006.

Among the factors underlying these housing market excesses was the extraordinary easing in monetary policy following the bursting of the dot.com bubble in early 2001. Already by 2003, the Federal Reserve had reduced interest rates to as low as 1 percent and the Fed was very slow in restoring interest rates to more normal levels over the next three years. Equally important in explaining the housing market boom was an unprecedented easing in mortgage-lending standards and the introduction of exotic lending instruments like Adjustable Rate Mortgages or negative amortizing loans. As a result of these innovations, by 2006 as much as 20 percent of overall mortgage lending was in the form of sub-prime lending to borrowers with poor credit histories, who previously would not have remotely qualified for housing loans.

Like all good things, the housing market party, too, appears to have come to an end. As housing has become ever-less affordable, housing prices, which were increasing at an annual rate of 15 percent as late as mid-2006, have now flattened out or started to decline. At the same time, vacancy rates have surged to record levels, while the stock of unsold homes has risen to over 7 months' supply thereby adding to the downward pressure on home prices. And to crown it all, the regulators, who were pretty much asleep while the party was in full-swing have now taken it upon themselves to tighten lending standards.

Despite the many assurances from policymakers that the worst is behind us, the outlook for the US housing market is now clouded by a whole host of factors that suggest that housing demand is likely to dry up at the very time when the market is characterized by oversupply. The mounting trouble in the sub-prime market space has already resulted in the shutting down of 30 sub-prime mortgage lenders and defaults on sub-prime mortgages are expected to result in around 500,000 foreclosed homes returning to a saturated market over the next six months. To make matters worse, the resetting at higher interest rates of around $500 billion in adjustable rate mortgages is only likely to compound a difficult situation in the sub-prime mortgage space, while the generalized tightening in mortgage lending standards is likely to further restrict overall housing demand.

In the months ahead, as housing prices inevitably fall under the weight of excess supply and of the unwinding of large speculative positions, one must expect that the overall U.S. economy will be negatively impacted in a material way. Sharply lower residential construction activity and employment alone could shave a full 1 1/2 percentage points from GDP growth in 2007. More important still, in the same way that increasing home prices induced U.S. households to run down their savings when the housing boom was in full swing, declining home prices could induce those same households to replenish their depleted savings. Since household consumption constitutes 70 percent of GDP, any attempt by households to rebuild their savings through lower consumption expenditure could have a large impact on the overall economy.

If the experience with the bursting of the dot-com bubble is any guide, the last thing that one would now want would be for policymakers to confine themselves to a cheerleading role. Rather, one would hope that the Federal Reserve anticipates the coming housing-induced economic slowdown and that it stands ready to aggressively ease monetary policy as needed to soften the fallout from the coming housing bust.